Friday, December 30, 2016

A year
ago, Steve
Sears of Barron’s
asked me to pen a guest column for The
Striking Price and use the opportunity to opine on how I saw the volatility
landscape unfolding in 2016. Without
thinking about it too much, I was fairly certain I was going to devote the
column to the many threats that had the potential to spiral out of control
during the course of the year, but before I had an opportunity to start translating
my thoughts into writing, other pundits started weighing in with their
predictions for 2016 and without exception, everyone who ventured a guess on
the direction of volatility was adamant that volatility would be substantially
higher in 2016 than 2015.

Not
wanting to follow the herd and always on the lookout for a more provocative
point of view, I decided to fade the consensus, rip up the script in my head
and adopt a contrarian outlook: The
Case Against High Stock-Market Volatility in 2016. The column began as follows:

“Looking at all the market predictions for
2016, one thing is certain: Almost all of the pundits agree that volatility
will be up, making a bet on rising volatility one of the year’s most popular
trading ideas.

But, as is the case with much of the
investment landscape, when most of the pundits agree about how the future will unfold,
it pays to investigate the contrarian point of view.

As to volatility, the contrarian perspective
is particularly compelling for 2016 because volatility is notoriously hard to
predict; investors have a habit of dramatically overestimating its future
level; and, when it comes to forecasting the causes of volatility, “experts”
and investors alike have a penchant for fighting the last war.”

Then
came January. For those who have tried
to put it out of their memory, January was one of the worst first months on
record, with the S&P 500 Index falling 7.3% for the month. The bearish trend continued into February, as
fears related to China and crude oil had investors selling en masse. By the time stocks found a bottom on February
11th, the S&P 500 Index was down 11.4% -- by some measures the
worst beginning for stocks in history.
Volatility, of course, was spiking and the VIX had already topped 30.00
on three separate occasions just seven weeks into the year.

My
prediction of lower volatility: complete
idiocy.

But the
year was not over and we still had to grapple with Brexit, the crazy
and unpredictable election season in the U.S., a Fed interest rate hike and
persistent political turmoil in places like Italy and Brazil. Amazingly, stocks showed a tremendous amount
of resiliency and all the VIX spikes
were given the Whac-A-Mole treatment as VIX mean
reversion emerged as a key theme during 2016.

Now
that the year is (almost) in the books, it turns out my contrarian low
volatility prediction was spot on and the rest of the pundits ended up on the
wrong side of a crowded losing trade, assuming one was patient enough to take a
full-year perspective. Genius? Probably not, but definitely more right than
wrong, despite my having to wear a dunce cap for the first two months of the
year.

The
graphic below shows the annual average VIX and historical
volatility going back to 1990. Note
that while the average VIX fell from 16.67 to 15.83 this year, there was an
even larger drop in realized or historical volatility, which fell sharply from
15.53 to 13.14.

[source(s): CBOE, Yahoo, VIX and More]

As far
as takeaways are concerned, there is the obvious lesson regarding the herd
mentality and crowded trades.
Additionally, there are also issues regarding how investors frame a
problem or potential problem. For
example, when one expects an increase in volatility they are more likely to be
overprepared for that development and/or overreact when there are initial signs
of an increase in volatility.
Ironically, if investors load up on SPX puts or VIX calls, then this
makes it much more difficult for panic to filter into the market. This leads to a theme that has been repeated
often in this space: VIX spikes are
notoriously difficult to predict and it is also more difficult to anticipate a
change in volatility regimes than many believe.

Last
but not least, as the graphic above shows, predictions of future volatility almost
always overshoot realized volatility, which is why in the last 27 years only the
extreme turmoil in 2008 saw realized volatility higher than the VIX over the
course of a full year.

A year
ago, Steve
Sears of Barron’s
asked me to pen a guest column for The
Striking Price and use the opportunity to opine on how I saw the volatility
landscape unfolding in 2016. Without
thinking about it too much, I was fairly certain I was going to devote the
column to the many threats that had the potential to spiral out of control
during the course of the year, but before I had an opportunity to start translating
my thoughts into writing, other pundits started weighing in with their
predictions for 2016 and without exception, everyone who ventured a guess on
the direction of volatility was adamant that volatility would be substantially
higher in 2016 than 2015.

Not
wanting to follow the herd and always on the lookout for a more provocative
point of view, I decided to fade the consensus, rip up the script in my head
and adopt a contrarian outlook: The
Case Against High Stock-Market Volatility in 2016. The column began as follows:

“Looking at all the market predictions for
2016, one thing is certain: Almost all of the pundits agree that volatility
will be up, making a bet on rising volatility one of the year’s most popular
trading ideas.

But, as is the case with much of the
investment landscape, when most of the pundits agree about how the future will unfold,
it pays to investigate the contrarian point of view.

As to volatility, the contrarian perspective
is particularly compelling for 2016 because volatility is notoriously hard to
predict; investors have a habit of dramatically overestimating its future
level; and, when it comes to forecasting the causes of volatility, “experts”
and investors alike have a penchant for fighting the last war.”

Then
came January. For those who have tried
to put it out of their memory, January was one of the worst first months on
record, with the S&P 500 Index falling 7.3% for the month. The bearish trend continued into February, as
fears related to China and crude oil had investors selling en masse. By the time stocks found a bottom on February
11th, the S&P 500 Index was down 11.4% -- by some measures the
worst beginning for stocks in history.
Volatility, of course, was spiking and the VIX had already topped 30.00
on three separate occasions just seven weeks into the year.

My
prediction of lower volatility: complete
idiocy.

But the
year was not over and we still had to grapple with Brexit, the crazy
and unpredictable election season in the U.S., a Fed interest rate hike and
persistent political turmoil in places like Italy and Brazil. Amazingly, stocks showed a tremendous amount
of resiliency and all the VIX spikes
were given the Whac-A-Mole treatment as VIX mean
reversion emerged as a key theme during 2016.

Now
that the year is (almost) in the books, it turns out my contrarian low
volatility prediction was spot on and the rest of the pundits ended up on the
wrong side of a crowded losing trade, assuming one was patient enough to take a
full-year perspective. Genius? Probably not, but definitely more right than
wrong, despite my having to wear a dunce cap for the first two months of the
year.

The
graphic below shows the annual average VIX and historical
volatility going back to 1990. Note
that while the average VIX fell from 16.67 to 15.83 this year, there was an
even larger drop in realized or historical volatility, which fell sharply from
15.53 to 13.14.

[source(s): CBOE, Yahoo, VIX and More]

As far
as takeaways are concerned, there is the obvious lesson regarding the herd
mentality and crowded trades.
Additionally, there are also issues regarding how investors frame a
problem or potential problem. For
example, when one expects an increase in volatility they are more likely to be
overprepared for that development and/or overreact when there are initial signs
of an increase in volatility.
Ironically, if investors load up on SPX puts or VIX calls, then this
makes it much more difficult for panic to filter into the market. This leads to a theme that has been repeated
often in this space: VIX spikes are
notoriously difficult to predict and it is also more difficult to anticipate a
change in volatility regimes than many believe.

Last
but not least, as the graphic above shows, predictions of future volatility almost
always overshoot realized volatility, which is why in the last 27 years only the
extreme turmoil in 2008 saw realized volatility higher than the VIX over the
course of a full year.

Purpose of this Blog

The intent of this blog is to educate, inform and entertain readers, while also serving as an archived learning laboratory of sorts as I try to sharpen my thinking in areas such as volatility, market sentiment, and technical analysis. I also enjoy charging off on tangents and hope that readers may find some illumination or at least amusement in these forays.

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About Me

Chief Investment Officer at Luby Asset Management LLC in Tiburon, California. Previously worked as a full-time trader/investor and also a business strategy consultant. Education includes a BA from Stanford and an MBA from Carnegie Mellon.
Useless trivia: I once broke the world pogo stick jumping record without knowing it.